Kevin Drum - November 2011

How Deleveraging in Europe Might Doom the U.S.

| Tue Nov. 22, 2011 2:42 PM EST

Both Paul Krugman and Tyler Cowen recommend a new paper from Hyun Song Shin called "Global Banking Glut and Loan Risk Premium." If both of those guys say a paper is important, then it's probably pretty important. So I took a look. I'll confess up front that I had a hard time plowing through it, which means my summary might be off base a bit here and there, but here we go anyway. Roughly speaking, Shin says the following things:

  • Credit expands when banks lever up their balance sheets by piling up lots of debt.
  • Thanks to Basel II, European banks levered up even more than U.S. banks.
  • Some of this was intra-European debt, but lots of it was U.S. debt denominated in dollars. In total, European banks had about $5 trillion in claims on U.S. counterparties in the peak year of 2007, much of it via purchase of private label subprime securitizations.
  • In other words, the European segment of the shadow banking system was indirectly providing about $5 trillion in credit to U.S. borrowers. This was about as much as U.S. banks provided directly.
  • The mechanism for this indirect flow was simple. Starting in 1999, U.S. money began flowing in large quantities to the U.S. subsidiaries of European banks, then across the Atlantic to their home offices in Europe, and from there back to borrowers in the U.S.
  • Conclusion: the European banking sector provides about as much credit to the U.S. as the American banking sector does. So when the European banking sector deleverages, as it must, it will have a very substantial effect on credit conditions in the U.S. In Shin's bland phrasing, "The European crisis carries the hallmarks of a classic 'twin crisis' that combines a banking crisis with an asset market decline that amplifies banking distress....The global flow of funds perspective suggests that the European crisis of 2011 and the associated deleveraging of the European global banks will have far reaching implications not only for the eurozone, but also for credit supply conditions in the United States and capital flows to the emerging economies."

Translated, this means that as sovereign debt woes get worse, bank woes get worse too. And as bank woes get worse, sovereign debt woes get worse. The result is a vicious circle that produces a big credit contraction, and since European banks have become so important as funding sources to the U.S., it means a big credit contraction in the U.S as well.

Tyler's comment: "If true we are doomed." On a separate note, Shin also points out that after the euro was introduced in 2000, cross-border claims within Europe skyrocketed. Unfortunately, banks themselves mostly stayed pretty local:

The introduction of the euro meant that “money” (i.e. bank liabilities) was free-flowing across borders in the eurozone, but the asset side remained stubbornly local and immobile. It is this contrast between the free-flowing liabilities but localized assets of European banks’ balance sheets that has been a key contributing factor in the European crisis.

In other words, wholesale funding flowed easily to wherever it would get the best return, but banks mostly kept their loan books local. This produced big property bubbles in Ireland and Spain and big current account imbalances across the entire continent. There's no easy way for this to unwind, and unfortunately, even the moderately difficult ways appear to be out of bounds to the eurozone's policymakers. If we really are doomed, it's partly because of bad policymaking during the aughts, but it's also because of disastrous policymaking right now. I wish I thought that Shin was wrong about this, but I suspect he's not.

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Mitt Romney in His Own Words

| Tue Nov. 22, 2011 1:16 PM EST

This is pretty funny. From ThinkProgress, it's Mitt Romney, in his own words, according to the Romney standard of accuracy. Enjoy.

Raw Data: The Laffer Curve for the Rich

| Tue Nov. 22, 2011 12:05 PM EST

Okay, this isn't actually raw data. In fact, it's very, very cooked and calculated data. But just so you know, Peter Diamond and Emmanuel Saez have tried to calculate the tax rate on the rich that would maximize revenue to the government. Paul Krugman summarizes:

In the first part of the paper, D&S analyze the optimal tax rate on top earners. And they argue that this should be the rate that maximizes the revenue collected from these top earners—full stop. Why? Because if you're trying to maximize any sort of aggregate welfare measure, it's clear that a marginal dollar of income makes very little difference to the welfare of the wealthy, as compared with the difference it makes to the welfare of the poor and middle class. So to a first approximation policy should soak the rich for the maximum amount—not out of envy or a desire to punish, but simply to raise as much money as possible for other purposes.

Now, this doesn't imply a 100% tax rate, because there are going to be behavioral responses—high earners will generate at least somewhat less taxable income in the face of a high tax rate, either by actually working less or by pushing their earnings underground. Using parameters based on the literature, D&S suggest that the optimal tax rate on the highest earners is in the vicinity of 70%.

Actually, Krugman is being conservative here. If you assume a broad base and no deductions, Diamond and Saez peg the revenue maximizing rate for top earners at 76 percent. That's for federal income tax only. (See page 173 here.)

You can decide for yourself if you think top marginal rates should be that high. After all, revenue maximization isn't our only social goal. Roughly speaking, though, this is a calculation of the peak of the famous Laffer Curve. (For top earners, anyway.) Above 76 percent, you really can generate higher revenues by lowering tax rates. Below that, higher rates generate higher revenue, just like you'd think.

Note that this is a result that both liberals and conservatives ought to take some satisfaction in. For liberals, it's confirmation that current tax rates are far, far below the Laffer maximum. We can raise marginal rates from 35 to 40 percent with only minor deadweight losses. For conservatives, it's justification for the 1981 Reagan tax cuts. When top rates were at 70 percent, reductions may not have literally paid for themselves, but they probably lowered revenue fairly modestly. We really were pretty close to the Laffer maximum in the '60s and '70s.

Quote of the Day: Mitt Romney's Lie

| Tue Nov. 22, 2011 11:13 AM EST

From Barack Obama, in Mitt Romney's latest ad:

If we keep talking about the economy, we're going to lose.

What Obama actually said, campaigning against John McCain on October 16, 2008:

Senator McCain's campaign actually said, and I quote, "if we keep talking about the economy, we're going to lose."

Just out of curiosity: How flat-out, knowingly false does something have to be before the press is willing to just call it a lie? We're about to find out!

Telling the Truth About Politics

| Tue Nov. 22, 2011 10:41 AM EST

From an LA Times editorial this morning:

Engaging in self-caricature, the Republicans insisted on no new taxes, a posture they modified slightly to propose $250 billion in new revenues, some offset by their other proposals, including making the Bush-era tax cuts permanent. Democrats, meanwhile, irresponsibly resisted meaningful cuts in domestic programs. Hobbled by their dogmatic opposition to taxes, the Republicans were arguably more intransigent. But both parties deserve blame for the anticlimactic outcome of the committee's work. The super committee was supposed to cut through the partisan pettiness that prevented a deal as part of the process to raise the federal debt ceiling. Instead, "super" proved to be SOP.

Can we please cut out this brand of horseshit? The facts: Democrats initially proposed a plan that, among other things, included $500 billion in Medicare and Medicaid savings and several hundred billion dollars in Social Security savings via a new inflation formula. Republicans responded with a package that was pure spending and benefit cuts. They followed that with a plan that included $300 billion in tax increases paired with an extension of the Bush tax cuts, which was very plainly a net tax decrease that exploded the deficit rather than reducing it. Democrats responded with a revised plan that included new revenues plus substantial cuts to Medicare, Medicaid, Social Security, and other domestic programs. In other words, Democrats were willing to propose cuts in domestic programs. It was exactly the same dynamic that played out during the debt ceiling debacle, with Obama persistently offering up big plans that included significant entitlement cuts and Republicans flatly rejecting them because they also included new revenues.

Look: Democrats are no angels. They're politicians, and they're driven by the same grubby political motives that animate all politicians. But Republicans are "arguably" more intransigent? "Both parties deserve blame"? Come on. What exactly would Democrats have to have done in order to avoid this lazy formulation? How much compromise were they supposed to offer in the sure knowledge that every single one of their offers would be rejected out of hand if it included even a dime of tax increases?

This is ridiculous. When is the American media going to ditch its obsession with looking neutral at all costs and simply tell its audience the actual truth? Tomorrow would be a good time to start.

Newt Gingrich and the Treachery of the Budget Wonks

| Mon Nov. 21, 2011 11:24 PM EST

It's hard to keep up with conservatives. One day the center of liberal treachery is the NAFTA superhighway, the next it's the Tides Foundation. Fast forward a few months and Agenda 21 is ruining the country, then a few weeks later it's the Fed. Trying to keep score at home is exhausting. Luckily, we have Newt Gingrich to clue us into the next conservative jihad:

The Congressional Budget Office is a reactionary socialist institution which does not believe in economic growth, does not believe in innovation, and does not believe in data that it has not internally generated.

The Congressional Budget Office! That's the shadowy cabal behind the decline of America! It's been the budget wonks all along!

So what's their sin? Beats me. At a guess, though, it's their general unwillingness to apply "dynamic scoring" to the fantasy-based budget plans concocted by Republicans. You know, the ones where a gazillion dollar tax cut supercharges the economy and generates ponies and surpluses as far as the eye can see. But the stodgy old CBO won't hear of it. They'll account for deadweight losses and other well-grounded economic effects that offset revenue losses from tax cuts a little bit, but that's all. No magic and no free lunches.

So Newt, the great conservative philosopher king, is mad at them. But there's not really any point in pretending to take this seriously. It just deserves a solid dose of mockery. So that's what it gets from Dan Drezner's Twitter feed. Enjoy.

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Please Give Me a Chance to Laugh at You

| Mon Nov. 21, 2011 6:27 PM EST

Just a quick note: Every pundit who laments the fact that President Obama didn't "do more" to get some kind of budget agreement through the supercommittee should be required to:

  • Explain exactly what Obama should have done.
  • Explain whether they think Republicans would ever, under any circumstances, have accepted a deal with a net tax increase.
  • If yes, provide details.
  • If no, explain why their hypothetical deal is any better, or more politically feasible, than the default trigger deal.

That's not so much to ask, is it? I should warn everyone ahead of time, though, that I mainly want answers to these questions so that I can laugh at you.

No More BRAC!

| Mon Nov. 21, 2011 4:04 PM EST

Stan Collender takes on one of my favorite pet peeves today, so I'll just turn the mike over to him:

For years I have been asked why we don't just set up a budget commission with rules like the base realignment and closure commissions of the past that have always been taken as the model for a successful commission. For the record, we had that here and it didn't work. Had the hardly-super committee actually recommended a deficit reduction plan, it would have used a BRAC-like process: the bill could not have been amended by Congress and would have been considered in both Houses on a simple up-or-down vote. No filibusters allowed.

BRAC was created to do something very different from the super committee: it was designed to determine which military facilities should be closed after Congress decided that some weren't needed. By contrast, the super committee had to do the equivalent of determining whether any bases should be closed at all. That was a far more open-ended and considerably more difficult task than anything any BRAC was ever asked to do.

I am so tired of BRAC I could scream. As near as I can tell, every hard problem of the past 20 years has produced suggestions that we need "something like BRAC." But guess what? The BRAC concept has only ever worked for one thing: closing military bases. If there's a silver lining to the failure of the supercommittee to do anything, maybe, just maybe, it will be the death knell of calls for another BRAC.

We don't need another BRAC. What we need is two political parties that are able to act in at least tolerably sensible ways on at least sporadic occasions. So far we only have one.

Wonks Agree: Supreme Court Will Uphold Obamacare

| Mon Nov. 21, 2011 2:29 PM EST

A couple of political science wonks pull out some charts today to try to predict what the Supreme Court will do about Obamacare:

As always, predictions are hard, especially about the future (see Berra v. Bohr) and especially when it isn’t clear which precedents apply or which legal doctrines are likely to dominate. Thus, any specific prediction must go beyond the model.

That said, here is ours: 6-3 or 7-2 to uphold the law.

Respect for precedent pushes Kennedy to support the law and Roberts comes along for the ride in order to keep the opinion out of Kennedy’s hands (and possibly writing an opinion that cabins the Commerce Clause more than it is now). Alito probably goes with Roberts, but seems more up for grabs. If we are wrong, expect the justices to either downplay precedent and emphasize other legal values (such as federalism) or play up the few precedents that protect state rights.

Policy motivations won’t be irrelevant, but score this one for law.

Hey, they stole that from me! But they have actual arguments to back themselves up. And a book. Check it out.

Quote of the Day: Profiting From the Misery of Millions

| Mon Nov. 21, 2011 1:47 PM EST

Like all right-thinking people, Felix Salmon is aghast at the austerity measures being implemented in Europe. After all, austerity won't help during a liquidity crisis, which means that in addition to hurting ordinary citizens, "it will harm the fat-cat bankers, too." But then he goes a bit beyond even right-thinking conventional wisdom:

But here’s the cunning bit: the bankers don’t really have their banks’ best interests at heart. They just want to keep on getting their coupon payments until this year’s bonuses are paid. And then, once those bonus checks are cashed, they’ll start trying to get next year’s bonus payment, too.

The bankers and technocrats know full well that the longer they manage to kick the can down the road, the worse it’ll be for everybody in the long run. But in the short run, they get very wealthy. Even as crucial government services are cut to the bone, and the risk of major social unrest increases greatly.

Are they really that cynical? Maybe so. Are they consciously that cynical? I'd guess probably not. Man is a rationalizing animal, after all. As Upton Sinclair famously said, "It is difficult to get a man to understand something, when his salary depends upon his not understanding it." And bankers have mighty big salaries.